whyyqyp traditional equity portfolio risk · 2010. 9. 23. · whyyqyp traditional equity portfolio...

Why traditional equity portfolio risk y q y pmeasures fail long-term investors

The Way Forward a.k.a.

Standing for Real Action

Dr Manny PohlManaging Director &

Investment Committee ChairHyperion Asset Management

“ b k ‘ l f f f ’ ”This communication is not a securities recommendation.

Any person considering action on the basis of this communication must seek individual advice relevant to their particular

“To quote my broker, ‘Past results are no guarantee of future performance’.”

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Any person considering action on the basis of this communication must seek individual advice relevant to their particular circumstances and investment objectives.

Traditional equity portfolio risk measurement fails long-term investorsfails long term investorsModern Portfolio Theory fails long-term investors by:

• Assuming risk is symmetrical when it is one sided• Ignoring agency issues

F i th h t t• Focusing on the short-term• Being pre-occupied with quant• Overlooking the quality of the underlying businessesg q y y g• Being based on unrealistic assumptions• Encouraging diversification as a substitute for due diligence• Promoting relative returns versus absolute outcomes for clients• Promoting relative returns versus absolute outcomes for clients

Thereby resulting in incorrect risk assessments and sub-y goptimal returns for investors

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“It sounds a little too perfect. What’s the downside?”

Failure 1. Assuming risk is symmetrical when it is really one sidedreally one sided

Expected return

Risk is the component of the uncertainty of future events relating

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p y gspecifically to the probability of an adverse outcome

“ ’d h b h f h bl h i f h l i ”

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“I’d rather be a huge part of the problem than a tiny part of the solution.”

Failure 2. Agency Risk

• Investment risk versus business risk - Agency issues di b h li fcreate a disconnect between the alignment of

investors and fund managers

• Investors wish to maximise returns… many managers y gwant to do this and maximise their FUM. These objectives are mostly incompatiblej y p

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“On Wall Street today, the stock market corrected its previous correction,

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y, p ,and is pretty sure it’s got it right this time.”

Failure 3. Short-term focus

• MPT is based on measures of short-term volatility and• MPT is based on measures of short-term volatility and it can be proven to detract from long-term returns

Th i i i l id th t h t t h• There is empirical evidence that short-term share price movements are driven by factors other than i t i i lintrinsic value

• Monthly returns are much more volatile than 5 or 10 year returns and are more often negative than returns measured over the longer term

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Rolling Returns, P/E Ratio and EPS Growth for 1 Year

80%

100%

80%

100%

40%

60%

han

ge Monthly Rolling 1 yr Hist Index

40%

60%

han

ge Monthly Rolling 1 yr Hist Index

0%

20%

Pe

rce

nta

ge C

h Return

Monthly Rolling 1 yr EPS Growth

0%

20%

Pe

rce

nta

ge C

h Return

Monthly Rolling 1 yr EPS Growth

60%

-40%

-20%

An

nu

aliz

ed

P

Monthly Rolling 1 yr ch in PER

60%

-40%

-20%

An

nu

aliz

ed

P

Monthly Rolling 1 yr ch in PER

-100%

-80%

-60%

-100%

-80%

-60%

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Jun

-61

Jun

-63

Jun

-65

Jun

-67

Jun

-69

Jun

-71

Jun

-73

Jun

-75

Jun

-77

Jun

-79

Jun

-81

Jun

-83

Jun

-85

Jun

-87

Jun

-89

Jun

-91

Jun

-93

Jun

-95

Jun

-97

Jun

-99

Jun

-01

Jun

-03

Jun

-05

Jun

-07

Jun

-09

Jun

-61

Jun

-63

Jun

-65

Jun

-67

Jun

-69

Jun

-71

Jun

-73

Jun

-75

Jun

-77

Jun

-79

Jun

-81

Jun

-83

Jun

-85

Jun

-87

Jun

-89

Jun

-91

Jun

-93

Jun

-95

Jun

-97

Jun

-99

Jun

-01

Jun

-03

Jun

-05

Jun

-07

Jun

-09

Source: Credit Suisse, Goldman Sachs, DataStream, Hyperion Asset ManagementMar-10

Rolling Returns, P/E Ratio and EPS Growth for 10 Years

40%

50%

40%

50%

20%

30%

Ch

ange

Monthly Rolling 10 yr Index

20%

30%

Ch

ange

Monthly Rolling 10 yr Index

0%

10%

Pe

rce

nta

ge C

10 yr Index Return

Monthly Rolling 10 yr EPS Growth0%

10%

Pe

rce

nta

ge C

10 yr Index Return

Monthly Rolling 10 yr EPS Growth

-20%

-10%

An

nu

aliz

ed

Monthly Rolling 10 yr ch in PER

-20%

-10%

An

nu

aliz

ed

Monthly Rolling 10 yr ch in PER

50%

-40%

-30%

50%

-40%

-30%

12

-50%

Jun

-61

Jun

-63

Jun

-65

Jun

-67

Jun

-69

Jun

-71

Jun

-73

Jun

-75

Jun

-77

Jun

-79

Jun

-81

Jun

-83

Jun

-85

Jun

-87

Jun

-89

Jun

-91

Jun

-93

Jun

-95

Jun

-97

Jun

-99

Jun

-01

Jun

-03

Jun

-05

Jun

-07

Jun

-09

-50%

Jun

-61

Jun

-63

Jun

-65

Jun

-67

Jun

-69

Jun

-71

Jun

-73

Jun

-75

Jun

-77

Jun

-79

Jun

-81

Jun

-83

Jun

-85

Jun

-87

Jun

-89

Jun

-91

Jun

-93

Jun

-95

Jun

-97

Jun

-99

Jun

-01

Jun

-03

Jun

-05

Jun

-07

Jun

-09

Source: Credit Suisse, Goldman Sachs, DataStream, Hyperion Asset ManagementMar-10

“Here are some of my investment assumptions.Find something to base them on ”

“Here are some of my investment assumptions.Fi d hi b h ”

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Find something to base them on.”Find something to base them on.”

Failure 4. Pre-occupation with quant as the source of truthsource of truth

CEO f h dCEO comment of the day

”...be sceptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms... these models tend to look impressive... Beware of geeks bearing formulas.”

Warren BuffettWarren BuffettCEO

Berkshire HathawayBerkshire Hathaway

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“ i i id lif b h h h h l i h b ?”

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“Can a rising tide lift a boat that has a huge hole in the bottom?”

Failure 5. MPT overlooks the low quality of the underlying businesses in an indexunderlying businesses in an index

• MPT is preoccupied with indices as the basic d i f i kdenominator of risk...

A stock’s index weight is unrelated to its long-term return outlook

• Strong evidence exists that low quality/ high risk stocks produce lower returns over the long-termstocks produce lower returns over the long term

A i d i l lit t k• An index may comprise low quality stocks16

Failure 6. MPT incorporates unrealistic assumptions

• The assumptions:• Expected returns are normally distributed

• Investors are rational

• Risk is the variability of expected returns

d d h b k d• MPT does not distinguish between risk and uncertainty

• Real world outcome is very different – the real risk is h h f ll i k h i bili i k

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the short-fall risk not the variability risk

MPT may assume returns are normally distributed but evidence indicates otherwisedistributed but evidence indicates otherwise

As the quality of the firm

Speculative/ the firm

increases, the -100% long-term return outcome

becomes less

highly geared firms tend to produce low

returns on equity, becomes less likely and the

mean outcome starts to become

more

lower free cash flows, have wider

return distributions and

more representative of

the expected return

produce abnormally low

returns

E t d t

18Area under the green and red lines is the same

Expected return

“I was spreading some risk around, and

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p g ,apparently it all wound up in your portfolio.”

Failure 7. Diversification has been substituted for due diligencefor due diligence• Diversification has been seen as the safety net and

ignores the quality of the underlying businesses in theignores the quality of the underlying businesses in the portfolio

• High quality businesses:• High quality businesses:• provide less risk of bad return outcomes • are less likely to go bankrupt• are less likely to go bankrupt • are less likely to suffer permanent declines in free

cash flowcash flow• have better opportunities to grow their earnings

with lower fundamental risk

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“Something is definitely going on. We’re back to eating dog food.”

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g f y g g g g f

Failure 8. Relative short-term returns to investors are promoted ahead of long-term outcomesare promoted ahead of long term outcomes

• Clients perceive risk as absolute not relative…. p

Cash is the benchmark in a bear market however it’s b t l t it l ti d th dabout long-term capital preservation and growth and

matching the investment horizon to the investment bj tiobjectives

V l tilit i ti d li l th• Volatility is mean reverting and cyclical over the longer term and therefore of diminished importance

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Risk management tools for portfolio construction in the real worldin the real world

• Longer term focus in order to match investors’ time h ihorizons

• Insensitivity to indices use indices correctly as• Insensitivity to indices – use indices correctly as benchmarks over the longer term and not as the basis for portfolio constructionbasis for portfolio construction

• Due diligence on business quality rather thanDue diligence on business quality rather than unquestioning reliance on diversification so as to understand and manage shortfall risk

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Hyperion is a manager that produces long-term resultsresults

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Source: van Eyk

... and executes quality investing with absolute disciplinediscipline

Source: van Eyk

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Products, Platforms, Ratings and Blending

Focused on quality Same team for 14 yearsFully aligned – we eat our own cooking

Products: portfolios of approx 22 quality stocks

Ratings:L R d d

y g g

quality stocks

• Hyperion Australian Growth Companies Fund

• Lonsec – Recommended

• van Eyk – A

• Standard & Poors – Four Stars

• Hyperion Small Growth Companies Fund

Platforms:

• Morningstar – Recommended

• Zenith - Recommended

Blending:Platforms:• BT WRAP• Colonial First Wrap

i W

Blending:

Blend with an index fund or deep value manager

• Macquarie Wrap• NetWealth

Distribution:Pinnacle Investment Management 26